Ideas for Intelligent Investing

Patience Plus a Great Franchise Can Make You Wealthy

The 2nd tenet of my investing blueprint is Act Like an Owner. The 8th tenet is Practice Patience. A great business generates wealth over time. Owners of privately held great businesses know they have something special that is worth holding on to and passing on. They are likely to be naturally patient in holding on to their businesses. I recently came across an example that powerfully reinforces this lesson and shows that the rewards of private business ownership are also available in the stock market.

I saw a comment on an investing forum where a contributor noted that Berkshire Hathaway now enjoys a 27% dividend yield on its original purchase of Coca-Cola. The stock currently pays a dividend of $1.76 on an annualized basis and Berkshire’s cost in the stock is $6.50 per share on a split-adjusted basis ($1.76 / $6.50 = 27%).

It’s amazing to think that you could have put $1,000,000 in Coka-Cola stock in 1988 and today, on top of your unrealized capital gains, you would be receiving annual checks totaling $270,000. Moreover, the $270,000 would be likely to grow at 5-7% as far as the eye can see.

Buffett’s purchase of Coca-Cola is highly celebrated and studied. Buffett invested $1,299 million and it is now worth $11,176 million based on the August 31, 2010 closing price. That is an average annual return of 10.3%, assuming a holding period of 22 years. Buffett purchased shares of Coca-Cola during 1988 and 1989.

What’s interesting to me is not only Buffett’s Coca-Cola purchase and its results, but also how well you would have done if you had purchased shares in other leading franchises at the end of 1988.

Johnson & Johnson

Price 12/31/1988 – $3.45

Price 8/31/2010 – $57.02

Average annual return – 13.8%

Current dividend – $2.16

Dividend yield on cost – 63%

McDonald’s

Price 12/31/1988 – $4.42

Price 8/31/2010 – $73.06

Average annual return – 13.8%

Current dividend – $2.20

Dividend yield on cost – 50%

Exxon Mobile

Price 12/31/1988 – $5.48

Price 8/31/2010 – $59.11

Average annual return – 11.6%

Current dividend – $1.76

Dividend yield on cost – 32%

Pepsico

Price 12/31/1988 – $4.18

Price 8/31/2010 – $64.18

Average annual return – 13.42%

Current dividend – $1.92

Dividend yield on cost – 46%

Total returns would be considerably higher if the calculations included the reinvestment of dividends.

It is worth noting that these companies were very well established and widely followed in the late eighties. Their strong economics and competitive advantages were on display for any investor willing to take a look. In short, they were hiding in plain sight. Moreover, I could have found many other examples of companies with similar performance.

Most investors missed them because they were not “hot” or “exciting”.

Also, it is important to understand why these businesses were able to produce such impressive results. These types of businesses earn high returns on equity, typically 18-20% or higher. After paying dividends and repurchasing shares, they are able to increase their equity by 10-15% per year. This reinvested capital, in turn, earns a high rate of return owing to the businesses’ durable competitive advantages. The mathematics are the same as those in play if you kept adding money to a savings account; the unusually high rate of return is a function of the moats these businesses enjoy.

Finally, don’t forget that if you invest outside of a retirement account, the tax benefits to this type of investing are huge. Buffett points out that the deferred capital gains tax amounts to an interest-free loan from the government.

Today, many world-class global franchises are available at very reasonable prices. Smart investors have taken notice and are buying large numbers of shares. Take a look at the holdings of leading investors at gurufocus.com.

Remember, as we have learned from Buffett, sins of omission can be every bit as costly as sins of commission.

One thought on “Patience Plus a Great Franchise Can Make You Wealthy”

You have described the core of the Buffett approach very well. Many investors see the logic but still can’t discipline themselves to filter out the urge to look for more excitement and short term gain. Ultimately I think it all comes down to psychology and you need to train yourself to be patient!

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